Tuesday, September 15, 2009

A few readers have raised the issue of whether we should be worried about the negative growth of money and credit in recent months. M2 money supply has fallen about $70 billion from its March high, and total bank credit has dropped by almost $400 billion since its peak of last October. Despite these declines, my argument continues to be (this is the longest-running theme on this blog I think) that there is no shortage of money in today's economy, and therefore no need to worry that the economy is being starved of money and therefore at risk.

This first chart illustrates the sharp swings in M2 money growth over the past year. David Rosenberg worries that "the deflation in credit, wages and rent is a toxic brew." But when money and credit growth were surging in late 2008, he was even more bearish on the economy than he is now. The problem lies in taking things out of context. The recent slowdown in money growth should be seen as a reversal of the explosive growth of money in the Sep. '08 through Mar. '09 period. Money growth took off because of a surge in money demand which was accommodated by the Fed's ultra-easy monetary policy. That surge in demand was in turn a by-product of extreme fear that the global financial system was on the verge of collapse. Now that these concerns are fading, it is only natural that money demand should fall and money balances should shrink. And in any event, the year over year growth rate of M2 is still a very healthy 7.6%. Any faster and monetarists would start worrying about a big acceleration in inflation.

This next chart shows the velocity of M2 (how many times each dollar of M2 is spent per year). I've used reasonable estimates for the growth rates of nominal GDP and M2 in the third quarter: 5.6% and -3.3%, respectively. I've highlighted the uptick in velocity that these numbers reflect, which works out to an annualized rate of growth of about 9% in the current quarter. If money velocity continues to rise at this rate, then money balances can shrink by 3-4% and the economy can still enjoy 3-4% real growth. That velocity is now rising is a very important development, since velocity is the inverse of money demand. Money demand is falling, and money balances are getting spent, and that is a major factor pushing the economy forward.

This next chart shows M2 growth over the past 50 years. As should be obvious, money growth almost always picks up in advance of recessions and almost always slows down as the economy moves from recession to recovery. The current pattern of declining money growth is exactly what we should expect to see. Indeed, this chart suggests that money growth could slow a lot more and the economy could still enjoy healthy rates of growth.

Finally, this last chart shows the growth in Total Bank Credit over the past 15 years. I've estimated a trend growth line of 7.5% per year, which is a bit more than the 6% average growth in M2 over this same period, and just a bit slower than the 7.8% annualized growth in this series since 1973. What you see is that the slowdown in bank credit since last October is mainly "payback" for the unusually rapid growth in bank credit in the 2005-2008 period. One reason for the slowdown in bank credit is that banks have tightened their lending standards, and that is reflected in surveys of lending officers. Another reason is that a lot of people want to reduce their debt burdens these days; deleveraging is being actively pursued by individuals and corporations alike. Another reason is that government borrowing has surged and is displacing private borrowing. Taken in isolation, any of these reasons could be cause for concern, but in today's context it's not obvious that the economy is starved for money. Indeed, the growth in M2 money balances remains very healthy, and above all, the Fed remains extremely accommodative. The current level of bank credit outstanding is exactly in line with historic growth trends.

UPDATE: As supply-sider, I should add that while the availability of credit certainly facilitates growth, it is not essential for growth. Growth is not created by extending credit; growth is fueled by work, productivity, investment and risk-taking. The bulk of the credit extended in any given year comes not from newly-created money, but from money that has been earned by others and subsequently lent to borrowers.

11 comments:

Regarding the bank credit "trend line" and the current deleveraging process in many countries, it seems to me, utterly unfamiliar with monetary technicalities, that "there's plenty of money in the banks", but very little credit allocated now to corporations, small sized firms and households. At least that is now the situation in Spain, which I acknowledge can be quite different in United States. So ¿would it make sense that future expectations on inflation remain low, just because unwinding in the future reserves that remain idle in banks won't make a real impact on economy?

Things seem worse than they actually are. According to Merrill Lynch, in the first 8 months of this year investment grade corporate borrowers were able to raise about $220 billion in new cash through bond sales. Since early 2008 they have raised some $450 billion. Bank credit is down, but individuals have managed to increase total mortgage debt by over $700 billion, also according to Merrill Lynch. Some people are having real problems, of course, but in aggregate it's tough to see any major problem.

In any event, borrowing is not what drives inflation. Inflation happens when the Fed supplies more money to the world than the world wants to hold. That the dollar's value is falling, gold is rising, and commodity prices are rising are all signs that we may have an oversupply of money and thus a future problem in the form of higher inflation.

Instead of looking at reserves, I think it is better to just look at real-time prices like the dollar, gold, commodities, the yield curve, etc. They can tell you what is going on with intersection of money supply and demand.

I've known Rosenberg for a long time, and have always thought that he is very selective about the data or the facts that he uses to support his view of the world.

I don't pretend to be an expert on insider selling/buying. But I do know that most corporate insiders are granted stock options as incentives, and these options vest from time to time and have expiration dates. If the option is exercised in the money, it triggers a tax liability that can be considerable, and many executives thus routinely sell all or part of the shares that they receive when exercising their options. For many executives, the exercise of stock options may provide a considerable part of their annual compensation, thus limiting their ability to accumulate shares.

Apart from that, I am not aware of any academic studies that show a strong correlation between insider sales and the subsequent performance of stocks. If anyone does know of something along these lines, please let us know.

I would note that insider selling was reportedly huge last April and has continued to exceed buying ever since. Those who sold in April-June are not looking very smart right now; whether those who have sold more recently will prove to be prescient remains to be seen. At the very least this would suggest that insiders are not good judges of the future direction of the economy.

Just to add to Scott's answer to your question (a question I have had recently myself), I think at least part of the explanation for insider selling is that many folks were terribly underwater this spring and have decided to sell now that they are at a profit. This behavior seems very normal to me anytime we have had a steep plunge in the market followed by a relatively quick run-up. There is still a lot of fear in the market that we will have another crash (an understandable fear for anyone not a market professional) as evidenced by Scott's posts on current high levels of implied volatility and wide IG bond spreads. I'm only speculating, but I think these are good indicators of market fear felt by corporate insiders who want to get out when given the first opportunity to sell in more than a year.

Thanks for the answers,that makes sense to me. And another idea, corporations were forced to go deep cost cut - regular salaries were heavily down, and maybe the other part of the incentive - stock options went strongly up making huge equties overhang which is beeing sold now. So if that backs to normal it will be stock positive.Thanks againFamily Man

Public: Well, that's precisely what a lender would hope for, isn't it? The person you lend money to better do something productive with it, or you won't get your money back.

I think what you're referring to, though, is what happens when the Fed makes money too cheap. That encourages people to borrow money and speculate (e.g., by buying commodities and real estate), rather than to use the funds to engage in productive activities (e.g., new plant and equipment, training, computers, etc.). Inflationary monetary policy is bad because it steers money towards speculative activities and away from productive activities, with the result that living standards fail to rise.

I don't think money has been cheap enough for long enough to produce any speculative excesses. This economy is still in the process of transitioning out of the real estate and commodity excess/booms. Not sure what it's transitioning toward yet. Stocks are not overpriced. What asset is obviously overpriced? Gold is the only thing that comes to mind.